Competitive pressures in U.S. health care delivery are weak to nonexistent, and their absence is among the most important drivers of our country’s high medical costs. Effective competition requires multiple providers and/or substitutes, transparent prices, and budget-conscious buyers, but all three are missing or badly compromised in most markets for health care services. This was exacerbated by Obamacare, but even now there are developments in “retail” health care that show promise for the future of competition in health care markets. The situation is not irreversible, but some basic policy issues must be addressed.

“The discussion over health policy rages over who will pay — private insurance, companies, “single payer,” Obamacare, VA, Medicare, Medicaid, and so on — as if once that’s decided everything is all right — as if once we figure out who is paying the check, the provision of health care is as straightforward a service as the provision of restaurant food, tax advice, contracting services, airline travel, car repair, or any other reasonably functional market for complex services.”

We face a severe tradeoff in health care: how to provide for the needs of more patients (e.g., the uninsured, or a growing elderly population) without driving up the cost of care? As a policy matter, provider resources should not be viewed as fixed; their quantity and the efficiency with which those resources are utilized are responsive to forces that can be harnessed. Fixing the supply side of the health care market by improving the competitive environment is the one sure way to deliver more care at lower cost.

“Dominant hospital systems use an array of secret contract terms to protect their turf and block efforts to curb health-care costs. As part of these deals, hospitals can demand insurers include them in every plan and discourage use of less-expensive rivals. Other terms allow hospitals to mask prices from consumers, limit audits of claims, add extra fees and block efforts to exclude health-care providers based on quality or cost.”

Mathews’ article is gated, but Cochrane quotes enough of its content to convey the dysfunction described there. Also of interest is Cochrane’s speculation that the hospital contract arrangements are driven largely by cross subsidies mandated by government:

“The government mandates that hospitals cover indigent care, and medicare and medicaid below cost. The government doesn’t want to raise taxes to pay for it. So the government allows hospitals to overcharge insurance (i.e. you and me, eventually). But overcharges can’t withstand competition, so the government allows, encourages, and even requires strong limits on competition.”

The Role of Cross Subsidies

In this connection, Cochrane notes the perverse ways in which Medicare and Medicaid compensate providers, allowing large provider organizations to charge more than small ones for the same services. Again, that helps the hospitals cover the costs of mandated care, regulatory costs, and the high administrative and physical costs of running large facilities. It also creates an obvious incentive to consolidate, reaping higher charges on an expanded flow of services and squelching potential competition. And of course the cross subsidies create incentives for large providers to lock-in business from insurers under restrictive contract agreements. Such acts restrain trade, pure and simple.

Cross subsidies, or building subsidies into the prices that buyers must pay, are thus an impediment to competition in health care, beyond the poor incentives they create for subsidized and non-subsidized buyers. So the “who pays” question rears it’s head after all. When subsidies are necessary to provide for those truly unable to pay for care, it is far better to compensate those individuals directly without distorting prices. That represents a huge policy change, but it would also help restore competition.

Competitive Sprouts

John C. Goodman provides a number of examples of how well competition in health care delivery can work. Most of them are about “retail medicine”, as it’s been called. This includes providers like MinuteClinic (CVS), LASIK and cosmetic surgery, concierge doctors, and “retail” surgical services. Goodman also mentions MediBid, a platform on which doctors bid to provide services for patients, and Ameriflex, which matches employers with concierge doctors. These services, which either bypass third-party payers or connect employer-payers with competitive providers, are having a real impact on the ability of patients to obtain care at a lower cost. Goodman says:

“I am often asked if the free market can work in health care. My quick reply is: That is the only thing that works. At least, it is the only thing that works well.”

Conclusion

Some of the most pernicious Obamacare cross subsidies have been dismantled via elimination of the individual mandate and allowing individuals to purchase short-term insurance. Nonetheless, U.S. health care delivery is still riddled with cross subsidies and excessive regulation of providers, including all the distortions caused by third-party payments and the tax code. Many buyers lack an incentive for price sensitivity. They face restrictions on their choice of providers, they don’t know the prices being charged, and they often don’t care because at the margin, someone else is paying. Fostering competition in health care delivery does not necessarily require an end to third-party payments, but the cross subsidies must go, employers should actively seek competitive solutions to controlling health care costs, price transparency must improve, and consumers must face incentives that encourage economies.

Certain enterprises seem plagued by declining productivity and increasing costs, or what is sometimes called the “cost disease”. This includes such areas as education, health care, and infrastructure development. Prompted by a fascinating post by Scott Alexander at Slate Star Codex, John Cochrane boils things down to administrative bloat, sometimes caused by regulation. He also identifies a lack of competition as a cause of the bloat. To that I would add institutional arrangements like third-party payments that create gaps between the scheduled prices established by payers and the user’s willingness to pay. Ryan Bourne at the CATO Institute also comments on Alexander’s post; he presents a framework for analysis but demurs from weighing-in on the causes because the U.S. lacks a proper index of public sector output. He mentions Cochrane’s post, but essentially ignores his contribution to the discussion, which I believe is essential to understanding the phenomenon described by Alexander.

The facts are: 1) costs in K – 12 education have tripled since 1970 (but not the student population), while student achievement has remained flat; as a consequence, productivity in education has declined by two-thirds! Alexander notes, “College is even worse.” 2) The cost of health care has increased by 400% since 1970. While longevity has increased and treatments for many ills have improved, we have not enjoyed a 400% improvement in health care delivery and outcomes, and other developed countries achieve the same outcomes at much lower cost; 3) the cost of new infrastructure has increased drastically in the U.S. Alexander cites the cost of the new subway extension in New York City ($2.2 billion per kilometer) at a cost of about 10 – 50 times that of equivalent projects in other parts of the world. These are just a few examples.

What explains these rampant cost increases? Economists are often tempted to attribute such phenomena to “Baumol’s disease“, which holds that sectors in which productivity is relatively static will experience increasing costs due to advances in productivity in other sectors. A classic example is an orchestra. In the act of playing a particular piece of music, an orchestra today has about the same productivity as an orchestra of 200 years ago (though technology can make musicians more productive in other ways). But as productivity grows for workers in the rest of the economy, their real wages will increase. Musicians, and potential future musicians, will then face a steeper tradeoff in their decision to proceed with musical careers. This tendency will increase their reservation wages as musicians. Moreover, consumers achieving more affluence from their work in other sectors — higher real wages — may demand more concerts, and some of those benefits will flow to members of the orchestra.

Have the orchestra’s costs increased without any corresponding increase in real productivity? Well, that argument isn’t quite cinched, since the real wages of the orchestra members and the real revenue derived from their productivity have both increased. Nevertheless, Alexander presents data showing that the real pay of public school teachers, hospital workers, and most physicians (excepting some specialists) has been stagnant, so at least those crucial labor inputs do not account for the increasing costs. While the pay of construction workers has undoubtedly increased, it cannot plausibly account for the cost increases in infrastructure development. But here is Alexander:

“I don’t have a similar graph for subway workers, but come on. The overall pictures is that health care and education costs have managed to increase by ten times without a single cent of the gains going to teachers, doctors, or nurses.”

So what might explain the “cost disease” plaguing these sectors? Alexander discusses, and dismisses, several possible theories, and finally settles on a very partial cause: regulation. From personal experience, I can attest to the bizarre commitment of large pools of talent to regulatory compliance. And there is validity to the argument that this bloat is related to legal risks, which organizations attempt to mitigate by creating layers of controls. Cochrane agrees that the real answer is sometimes related to regulation, but the explanation is much broader:

“The ratio of teachers to students hasn’t gone down a lot — but the ratio of administrators to students has shot up. Most large public school systems spend more than half their budget on administrators. Similarly, class sizes at most colleges and universities haven’t changed that much — but administrative staff have exploded. There are 2.5 people handling insurance claims for every doctor. Construction sites have always had a lot of people standing around for every one actually working the machine. But now for every person operating the machine there is an army of planners, regulators, lawyers, administrative staff, consultants and so on.”

Cochrane shines a light on perhaps the most important reason for administrative bloat: an absence of competition:

“These are all areas either run by the government or with large government involvement. …with not much competition. In turn, however, they are not by a long shot ‘natural monopolies’ or failure of some free market. The main effect of our regulatory and legal system is not so much to directly raise costs, as it is to lessen competition (that is often its purpose). The lack of competition leads to the cost disease.

Though textbooks teach that monopoly leads to profits, it doesn’t. ‘The best of all monopoly profits is a quiet life’ said Hicks. Everywhere we see businesses protected from competition, especially highly regulated businesses, we see the cost disease spreading. And it spreads largely by forcing companies to hire loads of useless people.“

The quote of Sir John Hicks is particularly informative. Protection from competition means that profits are less risky. The protected monopolist’s profits might be limited by social contract, but they are subject to less business risk. Hicks’ observation suggests that monopolists are likely to take a more langourous approach to cost control.

There is another characteristic shared by public education, health care and infrastructure: not only do those enterprises face minimal, if any, competition, but there is a disconnection between the users of those services and the payers. The cost of public education to taxpayers often bears no relationship to their use of the system. The cost of health care is often borne by third-party payers, rather than patients. The users of public infrastructure are seldom asked to cover its costs. So while monopoly is worse than competition, third-party payments free users of the responsibility to make decisions at the margin, short-circuiting the role of consumer incentives in controlling costs. This could manifest in increasing marginal costs, but it is very likely to enable or even require administrative bloat to take place.

Free of competition, and with customers who do not face tradeoffs between usage and price, providers will manage both their services and costs based on rules established by third-parties, and worse, by multiple layers of payers (as when government subsidizes insurers, when employers offer insurance coverage, and when government subsidizes those employers for doing so). Third-party payers are sometimes lacking in information or direct control (e.g., taxpayers). Payers often face incentives that do not promote efficient delivery of services for which they are obligated to pay. The standards by which costs are justified are seldom subjected to a true market test.

If Cochrane is right, that cost disease is driven by administrative bloat, which in turn is often a consequence of regulation, a lack of competition, and third-party payments, then several general solutions suggest themselves: first, regulate lightly; second, promote competition; third, rely on direct, non-subsidized payments by users whenever possible. In education, these guidelines mean giving public schools more autonomy and allowing parental choice. For health care, they mean an end to mandates and regulatory burdens on insurers, employers and providers, allowing consumer choice in selecting health coverage, ending prohibitions on competition in the insurance marketplace, and eliminating tax subsidies. In infrastructure, the guidelines support streamlining the review process for infrastructure projects, avoiding subsidies to over-invest, relying more heavily on user fees to pay for infrastructure, and expanding the role of private developers and operators of infrastructure facilities.

In advanced civilizations the period loosely called Alexandrian is usually associated with flexible morals, perfunctory religion, populist standards and cosmopolitan tastes, feminism, exotic cults, and the rapid turnover of high and low fads---in short, a falling away (which is all that decadence means) from the strictness of traditional rules, embodied in character and inforced from within. -- Jacques Barzun